Amid the parade of drab and not-so-heartening economic news these days, one bright beacon stands out: America’s oil-and-gas industry is rapidly pushing us toward (gasp!) energy independence.
According to Bank of America Merrill Lynch, domestic shale-oil production is expected to quadruple by 2014 from its level only four years previously. A recent Wall Street Journal analysis predicted that the United States will overtake Russia in 2013 as the world’s largest producer of oil and natural gas.
If we were earlier in the market cycle, I would advise you to buy shares of some domestically focused oil companies. With the S&P 500 up more than 150% since the March 2009 low, however, I’m wary. Rather than hope for capital gains down the road, I want to collect as much of my return as possible up front—in the form of cold, hard cash.
Master limited partnerships fit the bill perfectly. In particular, I favor MLPs that operate “toll taker” businesses with repetitive, annuity-like income streams: pipelines, storage terminals, natural-gas processing plants, etc. These partnerships not only dish out an ample cash yield but also possess the financial ruggedness to ride through all sorts of economic ups and downs— even crises like that of 2008.
A Nifty Tax Break, Too
Better yet, toll-taker MLPs let you shelter much (sometimes all) of your quarterly cash distributions from current income tax. How? By passing through to you their hefty depreciation write-offs. Uncle Sam “recaptures” this untaxed income when you sell your partnership units, but that event may be many years from now.
The chief drawback to MLPs is that they create extra paperwork at tax time. If you prepare your own taxes, I encourage you to use a software package like TurboTax or Tax Cut to guide you through the thicket, although even these programs occasionally leave details unclear.
In addition, be aware of these tax wrinkles:
- Most MLP’s don’t generate their year-end K-1 forms (the equivalent of a 1099 form for corporations) until late February or early March. Eager beavers who like to file their taxes early will be frustrated.
- Don’t place MLP’s inside your retirement accounts. They can generate Unrelated BusinessTaxable Income. If you earn more than $1,000 of UBTI per year, the government will tax it. Since it’s difficult to determine in advance how much UBTI a partnership may earn in a given year, I recommend avoiding the problem altogether. Hold your units in a taxable account.
For additional background on the tax aspects of MLPs, visit the website of the National Association of Publicly Traded Partnerships (www.naptp.org). The tab marked PTP 101 will walk you through the .mechanics of partnership investing.
Still Some Great Yields
Like the broader stock market, MLPs have performed strongly in 2013, with the benchmark Alerian index rolling up a 21.8% total return during the first nine months of the year. Over the past 10 years, the average MLP has produced three times as much wealth as the S&P 500 index.
Remarkably, though, many MLPs are still throwing off handsome cash yields. Factor in the prospect of distribution increases in the years ahead, and you’ve got a vehicle that will hedge you against inflation as well as any likely rise in interest rates.
Here are two of my favorite buys right now:
After a disappointing 2012, Buckeye Partners (BPL) seems to be regaining its stride. On October 9, Buckeye announced it had signed a pact to buy 20 petroleum storage terminals, mostly on the East Coast, from Hess Corp. for $850 million. I expect this deal to give a noticeable lift to BPL’s cash flow in 2014, enabling the partnership to pick up the pace of its quarterly distributions. Current yield: 6.4%. Look for the cash payout to grow 4%–5% a year over the long run, slightly below the industry average (because Buckeye’s pipelines mainly transport refined products like gasoline and jet fuel, as opposed to crude oil direct from the fields). Nearly all of BPL’s debt carries a fixed rate—a helpful “insurance policy” if interest rates go up.
Plains All-American Pipeline
At first glance, a 4.7% yield from Plains All-American Pipeline (PAA) may not pop your eye out. However, this organization boasts extraordinary growth prospects. Plains owns pipelines and storage facilities serving just about all the major regions of North America that produce oil and natural-gas liquids. Over and above its 18,000- mile pipeline network, PAA boasts 5,400 railcars transporting oil and gas, 1,505 trailers, 800 trucksand 100 barges. Quite an inventory!
In early October, PAA jacked up its distribution for the 17th quarter in a row (a fat 10.6% increase from the year-ago period). What’s more, management predicted that the payout will climb another 10% in the next 12 months. Counting reinvested dividends and price gains, I figure you’ll double your money by 2018 or sooner.